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Production and insurance under regret aversion

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  • Wong, Kit Pong
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    Abstract

    This paper examines the behavior of a regret-averse producer facing revenue risk. To insure against the revenue risk, the producer can purchase a coinsurance contract with an endogenously chosen coinsurance rate. Regret-averse preferences are characterized by a utility function that includes disutility from having chosen ex-post suboptimal alternatives. We show that the regret-averse producer never fully insures against the revenue risk even though the coinsurance contract is actuarially fair. When the producer is sufficiently regret averse and the loss probability is high, we further show that the regret-averse producer chooses not to purchase the actuarially fair coinsurance contract. Even when purchasing the actuarially fair coinsurance contract is optimal, we derive sufficient conditions under which the regret-averse producer reduces the optimal output level as compared to that without the coinsurance contract. These results are distinct from those under pure risk aversion, thereby making the consideration of regret aversion crucial.

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    Bibliographic Info

    Article provided by Elsevier in its journal Economic Modelling.

    Volume (Year): 29 (2012)
    Issue (Month): 4 ()
    Pages: 1154-1160

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    Handle: RePEc:eee:ecmode:v:29:y:2012:i:4:p:1154-1160

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    Web page: http://www.elsevier.com/locate/inca/30411

    Related research

    Keywords: Insurance; Production; Regret theory; Revenue Risk;

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    References

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    1. Michael Braun & Alexander Muermann, 2004. "The Impact of Regret on the Demand for Insurance," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 71(4), pages 737-767.
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    3. David E. Bell, 1983. "Risk Premiums for Decision Regret," Management Science, INFORMS, vol. 29(10), pages 1156-1166, October.
    4. Sugden Robert, 1993. "An Axiomatic Foundation for Regret Theory," Journal of Economic Theory, Elsevier, vol. 60(1), pages 159-180, June.
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    8. Quiggin, John, 1994. "Regret Theory with General Choice Sets," Journal of Risk and Uncertainty, Springer, vol. 8(2), pages 153-65, March.
    9. Chad E. Hart & Bruce A. Babcock & Dermot J. Hayes, 2001. "Livestock Revenue Insurance," Center for Agricultural and Rural Development (CARD) Publications 99-wp224, Center for Agricultural and Rural Development (CARD) at Iowa State University.
    10. Loomes, Graham, 1988. "Further Evidence of the Impact of Regret and Disappointment in Choice under Uncertainty," Economica, London School of Economics and Political Science, vol. 55(217), pages 47-62, February.
    11. Loomes, Graham & Sugden, Robert, 1987. "Testing for Regret and Disappointment in Choice under Uncertainty," Economic Journal, Royal Economic Society, vol. 97(388a), pages 118-29, Supplemen.
    12. Machnes, Yaffa, 1995. "Deductible insurance and production," Insurance: Mathematics and Economics, Elsevier, vol. 17(2), pages 119-123, October.
    13. Yaffa Machnes & Kit Pong Wong, 2003. "A Note on Deductible Insurance and Production," The Geneva Risk and Insurance Review, Palgrave Macmillan, vol. 28(1), pages 73-80, June.
    14. Loomes, Graham & Sugden, Robert, 1982. "Regret Theory: An Alternative Theory of Rational Choice under Uncertainty," Economic Journal, Royal Economic Society, vol. 92(368), pages 805-24, December.
    15. Kit Wong, 2000. "Insurance and the behavior of competitive firms under revenue risks: a note," Journal of Economics, Springer, vol. 71(3), pages 305-314, October.
    16. Starmer, Chris & Sugden, Robert, 1993. " Testing for Juxtaposition and Event-Splitting Effects," Journal of Risk and Uncertainty, Springer, vol. 6(3), pages 235-54, June.
    17. Wong, Kit Pong, 2011. "Regret theory and the banking firm: The optimal bank interest margin," Economic Modelling, Elsevier, vol. 28(6), pages 2483-2487.
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    Cited by:
    1. Wong, Kit Pong, 2014. "Regret theory and the competitive firm," Economic Modelling, Elsevier, vol. 36(C), pages 172-175.
    2. Lin, Jyh-Horng & Hung, Wei-Ming, 2013. "A barrier option framework for bank interest margin management under anticipatory regret aversion," Economic Modelling, Elsevier, vol. 33(C), pages 794-801.

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